Current expected credit loss is a new reliable method

Do you know the expected credit losses for your business? If it is known, you will have better risk mitigation plans developed to minimize such losses as much as possible. CECL or Current Expected Credit Loss is such accounting standard introduced by FASB (Financial Accounting Standards Board), a new standard for measuring expected credit losses related to financial assets carried on a balance sheet (typically of financial institutions and fixed income asset managers).

Table of Contents

What does CECL stand for?

CECL’s complete form is Current Expected Credit Loss. Current Expected Credit Loss helps to know expected losses, rather than focusing on incurred losses.

Example – The companies earlier forecasted the bad debt amount based on the previous year’s amount. However, the past losses do not give a clear idea about the future expected credit losses. Thus, rather than relying on historical trends, one needs to adopt a predictive or forward-looking model to be able to predict expected credit losses and increase the accuracy rate.

“Financial assets” include loans, debt securities held to maturity, reinsurance and trade receivables, and net investment in leases, among others. CECL will replace the comparatively simple existing loss allowance standard which utilizes a backward-looking “incurred loss” model with a new forward-looking “expected credit loss” model, that takes into account more data points and forecasted future results. FASB issued the final Current Expected Credit Loss standard on June 16, 2016. However, it became operational in 2019. The new standard was effective for fiscal years beginning after December 15, 2019, for SEC filers (public entities required to file financial statements with the SEC) and for fiscal years beginning after December 15, 2029, for all other Impacted Institutions.

Current Expected Credit Loss (CECL) will impact U.S. banks, foreign banks with operations in the U.S., insurance companies, credit unions, and non-bank institutions that hold financial assets at amortized cost, such as employee benefit plans and not-for-profit organizations (“Impacted Institutions”).

Steps in Current Expected Credit Loss Model:

Current Expected Credit Loss (CECL) requires companies to have a proactive view of their potential credit losses and record an impairment (deduction) to their revenues as a result of potential losses. Below three tenets are among the most important:

It requires forward-looking data: This means it’s no longer sufficient to solely consider prior losses.
It requires that assets be grouped (“clustered”) by risk profiles rather than by type. This means loans and accounts receivable cannot be considered a single entity. Companies must be able to segment and define risk factors for each business relationship.
It requires consistent reporting for losses across a company so that a partner, like an auditor, can stress test. This includes monitoring and revalidation based on both company-specific and overarching market indicators.

The Current Expected Credit Loss Model applies to which companies?

There’s a misconception that Current Expected Credit Loss (CECL) only applies to financial institutions. The reality almost every company needs to be compliant with the Generally Accepted Accounting Principles (GAAP) – which means any company must be complaint which has a contractual relationship that will bring in cash in the future. Companies that extend business credit, for example, are obligated to be GAAP compliant. If your company issues the following, you’re required to comply with Current Expected Credit Loss (CECL).

Trade receivables
Loans
Net investments
Debt securities

Difference between the Old GAAP method and CECL Method

Existing incurred loss model (GAAP) — a loss is recognized when an event occurs that leads one to believe a loss is probable at a specific point in time; past events and the current state are considered, not future potential events.

Current Expected Credit Loss (CECL) model — a loss is recognized when consideration is given to the historical performance of the asset, the current state of the asset, and all future events that will lead to a loss regardless of how probable those future events are. Additionally, the new standard covers losses expected over the remaining life of the asset, not at a current point in time.

Generally Accepted Accounting Principles (GAAP)	Current Expected Credit Loss (CECL)
Backward-looking – Relying on historical and current collections patterns	Forward-looking – Predictive approach using best-in-class machine learning and AI models built on the market-leading database of commercial unsecured trade experiences
Manual – Too many dependencies on manual exceptions, rendering models unable to scale	Automated – A fully automated model building that combines both company-specific risk profiles and macro-economic factors
Reactive – Responsive to customer behavior	Predictive – Incorporates changes to individual company performance and global market events to provide a fully integrated view of risk
Portfolio/Asset-Based – Segmentation based on asset class and type. Applying distinct measures independently and rolling up.	Account-Level Risk Assessment – Evaluation of risk begins with a company, applies to all future obligations; adjusts for loss based on time left in the relationship

CECL imposes a much more rigorous analysis of financial assets that are held at amortized cost and therefore, requires impacted Institutions to modify their policies, procedures, methodologies, and systems to support the implementation of the new standard. CECL is a “principal-based” accounting concept; FASB does not specifically prescribe approaches for determining the expected loss allowance. Instead, impacted Institutions can implement custom methodologies that are specific and relevant to their circumstances. This presents an element of ongoing adjustment of the methodology as current circumstances change for a given institution. This concept also creates the need for impacted Institutions to document, justify and explain, when audited, the rationale for their decisions to take a specific course of action concerning CECL.

Benefits of Current Expected Credit Loss (CECL) model

The Current Expected Credit Loss (CECL) model is a predictive model, that predicts expected credit losses, what will be the value of assets after considering those losses, etc. It requires extensive market research and updates about the lending industry as a whole. It offers the below benefits:

The predictive model to estimate credit losses

The predictive model has more accuracy than historical models in predicting the credit impairment amount. The higher the accuracy the more the business is prepared for it.

Risk mitigation plans

Once the business is aware of expected credit losses, then it is easier to follow the risk mitigation process. It includes identifying risks, analyzing risks, evaluating the risks, and their impact and prioritizing them based on the magnitude of impact, finally developing risk mitigation plans, and finally monitoring them.

Working capital estimation

Current Expected Credit Loss also helps the business to determine its working capital requirement after considering the credit impairment into account. It’s all about how to manage risks without running into situations of not being able to meet the current obligations on time.

Budgets and AOP planning next year’s Budgets and the Annual operating plans can be prepared with more accuracy after considering the Current Expected Credit Loss. The variance between actuals and forecasted values will reduce and contingent liabilities can be mentioned.

Although Current Expected Credit Loss (CECL) initially creates a formidable challenge to Impacted Institutions, the results over time should be beneficial to these institutions as CECL analysis and feedback should help them make more informed and better credit decisions about their future asset portfolios and improve their financial performance.